Trade of the Day: Chesapeake Energy (CHK)

Turnaround trades are risky, but new management is a big positive

Once considered an industry darling, Chesapeake Energy (CHK) had nearly become a laughingstock, no pun intended.

But over the past year, the company has had to make difficult choices, including selling prized assets. Given its still-dominant role in the industry, and the initiatives it is taking to maintain market share, this is a good time to take a long-term position in Chesapeake.

Fundamental Check

Chesapeake is nearing its 52-week high of $22.97. At the time of publication, it was trading around $21.

When it reported first-quarter earnings in May, net income was $58 million, or 2 cents a share. That compares to a loss of $28 million it incurred during the same quarter in 2012. During the quarter, sales increased by 42% to almost $3.5 billion, continuing a four-year trend of improving top-line performance.

Chesapeake pays a 35-cent dividend that has a 1.7% yield. That kind of yield is useful to smooth returns and will be attractive to long term investors, but it’s also low enough to keep the stock safe from the capital flight out of higher-yielding stocks and rising bond yields.

A Look Back

A few years ago, natural gas prices seemed to have no upper limit. Chesapeake positioned itself to take advantage of the boom, producing so much natural gas that it was second only to Exxon Mobil (XOM).

Then things began to change for the industry in 2008. Natural gas prices began to decline, and Chesapeake found itself in the not-so-enviable position of having too many facilities producing the lagging commodity.

At the same time, signs of the company’s internal financial management problems began to rear their ugly heads. Investors may have understood the company’s profits taking a hit due to the nature of the business, but losing money because internal controls were weak is something entirely different and not easily digestible.

A Steadier Hand at the Helm?

There are few that would deny or downplay the role co-founder and former CEO Aubrey McClendon played in the success of Chesapeake Energy. There are even fewer that would deny the role he played in its fall. He was accused of spending lavishly on personal expenses, and the company’s Well Participation Program in which he was involved was criticized.

While McClendon was seen as brilliant for his role in steering Chesapeake’s growth into a behemoth in the industry, concerns over his use of company dollars to fund his personal life were ruining the company’s reputation. At the end of the day, a company’s value is only as good as its reputation. In Chesapeake’s case, investors and traders abandoned the company’s stock.

In the end, McClendon had no choice but to step aside. He retired in April 2013. McClendon’s retirement set the stage for Doug Lawler to be ushered in as CEO and for major changes to be made to help right the company’s financial ship and restore investor confidence. This is a positive step that we see as another reason to make Chesapeake a strong buy at this point.

Already, Lawler has set a goal of increasing the company’s production of liquid energy products. Diversifying production into propane, and oil in the wake of falling natural gas prices should help build long-term value. The company is already the eleventh largest producer of oil in the U.S.

That shift played a role in the company’s first quarter profits. Chesapeake has subsequently increased its target oil output to one million barrels for 2013. Still, natural gas is its bread and butter and accounted for more than three-fourths of its production during the first quarter. The company saw some relief as natural gas prices hit a 20-month high in the spring, which should contribute to future performance.

Importance of Asset Sale

Even with that relief, the company is not backing down from its asset sales, which is also a positive. A lot is riding on these transactions. Chesapeake’s financial situation had become so problematic that execs worried over being able to fund the company’s 2013 capital expenditure budget. Long-term debt and financial liquidity are the biggest problems plaguing the company.

This month Chesapeake announced the execution of agreements to sell assets in the Northern Eagle Ford Shale and Haynesville Shale to EXCO Operating Company, LP, which is a subsidiary of EXCO Resources (XCO).

The transaction will reap Chesapeake $1 billion. It will receive about 90% of the money at closing, which is expected to happen by the end of the third quarter. Company execs say the remaining proceeds will be distributed subject to “customary post-closing contingencies.”

Why Buy Now?

CHK is a classic turnaround, which presents great upside opportunities because the company is distressed. If management can use the capital from asset sales and higher margin production to regain its former standing in the industry, then the stock is severely undervalued. It should go without saying that turnarounds are also very risky. They are a bit like buying a non-expiring call option. The potential upside is very large, but losses could also be extreme if things don’t work out as planned.

Click to Enlarge The stock is currently channeling between $22 and $18 per share. This is a typical consolidation range for the stock over the last few years. A break of $22 has typically sent the stock into the $30-$35 range. However, despite the false alarm in the fourth quarter last year, a break below $18 per share usually precedes larger losses.

Recommendation: We recommend an early entry between $21 and $22 per share. However, stop losses should be set below $18 to prevent large losses. When the stock breaks above $22 per share we recommend moving the stop level up to $19-$19.50 to minimize the potential impact of a whipsaw. If CHK breaks out as we expect, our profit target is $30 per share, which is based on prior breakouts from this range in 2009 and 2010.

Options Alternative: The CHK September 22 calls will limit the potential downside in notional terms. Selling the call when/if the stock consolidates at $30 is our recommended exit plan at this point.

InvestorPlace advisors John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.

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